Cheap Corn Makes Cheap Hogs

That's the adage and it has historically been very true. It's corollary is that high-priced corn makes high-priced hogs. That one is a bit shakier but we know that, in the long run, the cost of inputs must be captured in the price of the product.

The increases in the prices of both corn and soybeans that have been driven by subsidized biofuels appear at present to be permanent. That judgment is based on two factors that are not likely to wane or disappear over the next few years: high oil prices and the political popularity of ethanol.

Figure 1 shows crude oil futures on four different days since early March of this year. While there has been some movement in these prices, note that the most recent set of observations is by far the highest of the group. The June 5 prices do not represent the high for crude oil futures (that came back in mid-2006) but the fact that they are still in the upper-$60s and lower-$70s indicate that market conditions have not gotten much better if you are on the buying side of the oil market. There is still ample worldwide demand for oil, and the supplies of oil are still limited and risky. Those translate into what is likely to be persistent high prices.

If we had a graph of the political popularity of ethanol, it might look much like the oil price graph -- and that similarity is no accident. In addition, the rhetoric regarding ethanol is at a four-year high, and highly correlated with the presidential election cycle. The political parties are trying to "out-renewable-fuel" one another and a veritable army of presidential candidates have now invaded Iowa and nary a bad word about biofuels will be uttered in their speeches.

The bottom line is, we have probably seen another major shift in corn prices. Figure 2 shows annual averages since 1908. Note that two major shifts have taken place in that time. The first was during and after World War II when wartime shortages, pent-up demand and a booming post-war economy drove corn prices from the 1908-1942 average of 78¢/bu. to a whopping $1.26/bu. -- an increase of 62% -- for 1943-1972.

The second jump occurred in 1973 when the Russian grain deal ushered in a new era of world trade in grain and eventually other agricultural products. That price increase, to $2.37/bu., amounted to 88%.

Note that the first period was 35 years and the second was 30. Now, 34 years later, we see another sea-change in the price of corn. Technical analysts would put a lot of stock in the 30-35 year period. I'm more inclined to write it off to coincidence. Regardless, it certainly is interesting that the period is relatively consistent and that this shift was right on schedule.

The $64 million question for the pork industry is "How will we adjust?" Corn prices that could well be in the $3.50 to $4.00 range for the foreseeable future have some analysts predicting lean hog prices of $100/cwt. or more. And some are predicting those within a couple of years.

But prices don't just adjust automatically. Either supply or demand has to shift. When corn prices jumped in 1974, the pork industry was poised to come out of a liquidation phase. High corn prices continued that liquidation, driving 1975 hog slaughter to its lowest level in a decade and basically precluding one cyclical increase in output. Cyclical highs occurred in 1971 and 1980, with nothing in the way of a cyclical high in between.

But the reason for that action was that producers lost money and continued to reduce output. It doesn't look to me like the present situation is going to cause the kind of producer losses that lead to output reductions. Cash hog prices and CME Lean Hogs futures have kept producers in the black so far. History tells us that producers simply do not cut back unless they actually lose money.

The more likely scenario is that production will remain relatively stable over the next few years since there is no incentive to cut back and the much lower margins will provide little incentive to expand. That means demand must be the driver of higher margins. Pork demand grows each year due to domestic population growth and more access to larger numbers of people in export markets. That growth, though, is pretty slow, so it may take awhile to restore the margins to which we have become accustomed.

The key assumption, of course, is that producers do not expand while margins are so low. I think that is a safe assumption except for the fact that producers' balance sheets are in such terrific condition. Many are going to want to "Do Something!" Will they diversify or "dance with who brung them" by expanding hog output even though the returns aren't as attractive as they once were?